Winter 2015

Risk Neutral Pricing and Global Bond Yields

Global bond yields are collapsing. Bond yields in almost every major economy — developed and emerging—are lower than they were 10 years ago. Bond yields in Greece have risen about 2 percentage points, but that’s because they’re having their own problems with staying in the Euro.

Collapsing bond yields have also flattened out the yield curve in the US, Germany, Japan, and the UK. These numbers are incredible. People arepaying the German government 3 basis points a year for a stretch of 5 years just for the government to hold their money! In Japan, the government is getting away with paying 0.2% for a 10 year bond.

Why might this be the case? There’s a few stylized facts to keep in mind.

This collapse is global.

Yield curves are flattening. Any story must have factors that can affect yields all the way 10 years out.

Based on these two facts, what can we rule out?

The reason for collapsing bond yields can’t just be relative currency appreciations. Uncovered interest rate parity predicts that countries with low bond yields have such low yields because the market forecasts that their currencies will appreciate. But this can’t be the case if everybody has much lower bond yields — there’s no currency to appreciate against.

Is it just oil? That’s certainly what a lot of the media thinks. I can’t rule it out. But if the driving story is oil, it must be that we expect oil prices to be continually falling over the course of the next 10 years. Low but stable oil prices aren’t enough. That would make the price level low now, but that wouldn’t generate a persistent downward pressure on the price level, i.e. disinflation. And given that oil is now as cheap as it was in 2003, this story seems implausible.

I want to entertain one more story — that the term premium is turning negative. The 10 year bond yield can be decomposed into three components: the real risk free 10 year yield, inflation expectations, and then a 10 year term premium that compensates people for holding longer term bonds. Research from the NY Fed finds that this term premium has been falling ever since the 1980’s. Why might this be?

One story that would explain this is based on the notion of risk neutral probabilities. In the canonical theory of asset pricing, current prices should be the discounted value of expected future scenarios under the risk neutral measure. What this concretely means is that future scenarios that “hurt” a lot in terms of lost consumption get weighted higher than their true physical probability, and that scenarios that hurt less are downweighted.

In normal times, it’s high interest rates that are bad times. High interest rates are times when the central bank tightens too much and pushes the economy into a demand side recession. But it’s not clear that’s the case any more. Think about Japan as an extreme example. The most plausible scenario in which Japanese bond yields rise is if the Japanese central bank manages to achieve its 2% inflation target. That would be incredible! It would make their debt burden so much more manageable and would definitely not be a “painful” state of the world.

This reweighting of probabilities translates into a negative term premium. Because risk neutral pricing means that you underweight the higher bond yield scenarios, bond yields will look “too low” if you compare them with the likely evolution of short rates.

Observe that this scenario can be global and highly persistent—satisfying the two stylized facts above. If there’s a global lack of aggregate demand, high inflation (and therefore high long term bond yield) states of the world are painless. Risk neutral pricing then means that the high interest rates states of the world should be discounted everywhere. These effects can also be highly persistent because they’re statements about monetary policy regimes.